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Yield Spread Not Confirming GDP Growth Story

The domestic economic growth story took a beating in the first quarter of this year with an initial estimate of just a 0.1% annualized growth rate. This smidgen of a growth rate was quickly blamed on the “winter weather” that occurred, ironically, during the winter. Recently received economic data for the first quarter now suggests the growth rate was likely negative.

The good news is that the weakness in Q1 will likely lead to another “inventory restocking” bounce in Q2 just as we have witnessed in each year since the financial crisis. To wit:

“With that inventory restocking cycle now complete, the current “Day After Tomorrow” syndrome will likely lead to another rundown/recovery cycle in the economy. The economic drag caused once again by “Mother Nature” combined with the impact from the onset of the Affordable Care Act is likely to keep economic growth suppressed below expectations once again this year.”

Economic data for April already suggests that this “restocking” cycle is underway. Production is up, but employment demands remain suppressed. This is because business owners are not producing for an increased surge in demand generated by a rapidly strengthening recovery, but rather just replacing drawn down inventories. This was clearly witnessed in the most recent employment report which showed hours worked increasing, but wages remained flat.

This data all suggests that while we will likely see a “pop” in economic activity in the second quarter, it will likely not be more than that. The reason I say this is simply because of the following chart.

One of the key indicators for economic growth, or lack thereof, is the direction of interest rates. When economic activity is truly rising, the demands for credit rise also. The chart above is the spread, or the difference, between the 30-year Treasury and the 10-year Treasury bond rates. When this spread is rising it corresponds with stronger demand for credit and rising economic growth. When the spread falls, it is more coincident with economic weakness.

The current decline in the spread suggests that “real” economic activity is likely weaker than headline data suggests. If that is indeed the case and economic activity does weaken in Q3 and Q4 of this year, then the current decline in rates is likely giving investors a clue. The chart below shows the 30-Treasury rate as compared to the S&P 500.

Not surprisingly, rising interest rates have corresponded with stronger economic activity and a rising stock market. Falling rates have also generally corresponded with market weakness or major corrections.

The good news is that the current decline in interest rates will likely stem the decline in the housing market in recent months. Those buyers that put off a purchase due to higher monthly payments will likely re-enter the market. However, this will be a very minor impact to the overall economy as housing makes up less than 3% of economic growth.

The bad news is that the current decline in rates is likely a warning sign that current market weakness could morph into something more important in the not too distant future. This doesn’t mean that we are about to encounter the next great market unwind, but a correction of 10% or more is not unlikely. The case for such a correction is further supported by the ongoing liquidity extraction by the Federal Reserve as they continue to taper the bond buying programs.

Over the last five years, there has been an ongoing “hope” for an economic resurgence. Each market and economic sputter was quickly met with an inflow of Central Bank intervention. Yet, each resurgence ultimately failed as the underlying economic dynamics of high unemployment, excess slack, stagnant wage growth and rising costs of living remain unaddressed.

The ongoing misinterpretation and massaging of economic data to spin a positive view on the economy is fine and good. However, real economic recovery must start with the average American since consumption makes up nearly 70% of economic growth. While the current Administration and Federal Reserve promote policies that are supposed to create economic prosperity for all, the reality is that remains bottled up on Wall Street. The following graph from Congressman Kevin Brady, Chairman of the Joint Economic Committee, shows the huge disparity between Wall Street and Main Street.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 16 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

A decline in savings rates to extremely low levels which depletes productive investments

An aging demographic that is top heavy and drawing on social benefits at an advancing rate.

A heavily indebted economy with debt/GDP ratios above 100%.

A decline in exports due to a weak global economic environment.

Slowing domestic economic growth rates.

An underemployed younger demographic.

An inelastic supply-demand curve

Weak industrial production

Dependence on productivity increases to offset reduced employment

The lynch pin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap” where maintaining ultra-low interest rates is the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

As I discussed recently, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near the peak of cyclical bull market cycles.

We saw much of the same analysis as Brad’s at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. It is likely that this time is “not different” and while it may seem for a while that Brad’s analysis is correct, it is ‘only like this, until it is like that.'”

About The Author

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.